Pitchbook recently released its 2018 results for cannabis related investments, and the data is impressive: 139 deals scooped up a whopping $881 million. Those numbers are up over the prior year by 26 percent (number of transactions) and 120 percent (total amount invested), reflecting larger average deal sizes. Leading the way, Privateer Holdings closed a $100 million Series C financing.

Clearly, the success of Canadian public offerings in the space is creating a “chimney” effect where a few big exits result in early-stage capital being pulled into the ecosystem.

The Pitchbook report also lists the top dozen cannabis-related venture investors, led by Altitude Investment Manage, Casa Verde Capital and Salveo Capital, each with six or more investments in 2018.

The addition of sophisticated, institutional capital to the cannabis marketplace is, from our perspective, a welcome game-changer. The net result is likely to be increased scrutiny on the quality of management teams, the scalability and defensibility of business models and heightened attention to corporate governance. All of which should lead to a more stable and ultimately more profitable industry for stakeholders.

Join the World Law Group for its upcoming webinar series on the legalization of cannabis around the world. Each of the four webinars will focus on specific jurisdictions or regions, including Europe, Israel, Canada, Latin America and the United States. Our very own Josh Ashby will serve as a moderator for the upcoming Israel update on February 26, and as a panelist for the U.S. update on April 3. Register via the links below.

“Audit,” already an unpleasant word in cannabis circles, got a little worse this week with the release of a stern assessment of Oregon’s cannabis program by the Oregon Secretary of State. The 42-page report, the first such review since Oregon voters legalized recreational marijuana in 2014, catalogues numerous gaps in Oregon’s regulatory oversight of cannabis. While offering qualified praise for the theoretical scope of Oregon’s adult-use regulations, the audit found that a lack of resources has led to spotty enforcement.

The audit is organized around four key findings:

Oregon Liquor Control Commission (OLCC) staffing and inspections have not kept pace with the number of licenses;

Oregon does not require that cannabis be tested for heavy metals or microbiological contaminants, jeopardizing public health; and

Oregon’s testing program does not do enough to ensure the accuracy of results and insulate labs from industry pressures away from best practices.

We’re still sifting through the findings, but initial review of the audit confirms what many already knew. There’s too much cannabis being produced by too many licensees — the audit estimates that Oregon can legally produce somewhere around five times more than the state consumes. Oversupply has pushed per-gram prices down over 50 percent since October 2016, incentivizing producers to divert cannabis outside of regulated channels and often across state lines.

Problems of oversupply and diversion are compounded by overmatched regulators. The OLCC’s ratio of inspectors to licensees (about 1:88) is among the lowest of adult-use states, while the OHA has six inspectors for over 7,000 grow sites (nearly 14,000, counting smaller home grows).

The audit also expresses concerns about consumer safety due to Oregon’s testing laboratories. Oregon requires testing for pesticides, but not heavy metals or microbiological contaminants. Testing requirements for medical marijuana, whose consumers are often particularly vulnerable to contaminants, are inconsistent. The testing that is required is performed by labs that lack consistent standards or compliance procedures, and that are subject to market pressures to provide favorable test results.

To their credit, the audited agencies agreed with the audit and its recommendations. Across the board, the issues raised by the audit are rooted in lack of resources, not lack of willingness. And while the audit is unsparing, this kind of tough love is necessary for the health of the industry as a whole. Consumer protection and robust oversight are crucial for a new industry, especially while pioneering states like Oregon try to avoid the ire of the federal government.

We will be spending more time with the audit results and discussing some of the specific implications for the future of cannabis Oregon here. Stay tuned!

With 10 states and the District of Columbia having legalized recreational cannabis (representing nearly a quarter of the U.S. population, including the most populous state), an emerging issue is how to deal with the odor generated by marijuana production facilities. A December 19, 2018 article in TheNew York Times noted a growing number of neighbors of cannabis farms are complaining about “skunky” odors caused by certain volatile organic compounds generated during growing and processing. The Times cited Sonoma County in California, which it reported received more than 730 complaints about cannabis last year, nearly two-thirds related to odor. Regulators at the state, regional and local levels are attempting to deal with these issues through a combination of permitting, land use and nuisance rules.

In states such as Washington and Colorado, where recreational cannabis has been legal since voter initiatives passed in 2012, regulators have addressed odor as an air quality issue. For example, in the Puget Sound region, the Puget Sound Clean Air Agency — typically recognized in the industry as “PSCA,” or the organization you may have received an unexpected and nondescript invoice from — does not have a specific regulation for marijuana odors. It does, however, have jurisdiction to impose limitations on marijuana production facilities under the state’s general regulations for air pollution sources (WAC 173-400). PSCA regulates odors through the Notice of Construction process, which operates in conjunction with local permitting processes, such as a conditional use permit, and licensing by the Washington State Liquor and Cannabis Control Board.

The PSCA odor regulations set a “best available control technology” (BACT) standard, which is the maximum degree of reduction for each air pollutant subject to regulation under the Washington Clean Air Act (RCW 70.94) that the permitting authority determines is achievable, taking into account energy, environmental, economic and other costs. PSCA’s rules are based on a nuisance standard — causing or allowing an air contaminant in sufficient quantities and of such characteristics and duration as is, or is likely to be, injurious to human health, plant or animal life, or property, or which unreasonably interferes with enjoyment of life and property.

For marijuana producers under PSCA’s jurisdiction (King, Snohomish, Pierce and Kitsap Counties), the agency has determined that BACT means no detectible cannabis odor outside the facility property line. The agency in recent permitting actions has implemented this standard by requiring operators to design all exhaust points (e.g., vents, stacks, windows, doors) associated with an enclosure, building or greenhouse for cannabis production or processing to continuously control odors and volatile organic compounds (VOCs) using carbon adsorption technology, which involves placement of carbon canisters before emission points. At a minimum, these carbon units must be replaced every quarter. An operator also must have a person who has not been exposed to the smell periodically monitor the air at the property line to determine compliance with the “no detectible odor at or beyond the property line” standard.

One significant ramification of this standard is that PSCA does not believe outdoor cannabis production facilities can continuously achieve the “no odor outside the property boundary” standard without the proper use of an enclosure that routes emissions to a carbon adsorption system. PSCA also does not allow odor masking, such as spraying a curtain of scented oil vapor around the perimeter of greenhouses. Although the Times article mentions this system as a way one California grow operation has tried to mitigate odors, PSCA will not accept that as a control technology.

In Colorado, cannabis cultivation facilities are designated as agricultural activity and exempt from state air quality regulations unless they are a major source of pollution. The City and County of Denver, however, has an odor ordinance that requires cultivation facilities control the odor impacts of their operations. An August 2018 draft of the Denver Department of Public Health & Environment’s “Cannabis Environmental Best Management Practices” (BMP) recommends use of carbon filtration to reduce the VOC emissions from a cannabis cultivator. In addition, draft guidance recommends other best management practices, including:

Regular inspection and maintenance of HVAC systems;

Sealing the grow space within a greenhouse and circulating air for approximately one week and purging exhausts during low ozone formation periods (evenings, windy days, cloudy days);

Ensuring temperature and relative humidity are under control and within tolerances so that high temperatures and humidity do not perpetuate odor issues;

Having a system in place to record and respond to odor complaints;

Purchasing a “scentometer” or Nasal Ranger to quantify odors and record data from self-testing;

Timing harvests to minimize ozone impact and minimizing emissions during morning, early afternoon and summer; and

Train and allocate responsibilities among staff members to ensure consistent and continuous implementation of BMPs.

Colorado facilities manufacturing marijuana-infused product are subject to health and safety regulations and regulations on extraction processes in the Colorado Code of Regulations. Those facilities must estimate their VOC emissions from solvent uses and follow the state’s Air Pollutant Emission Notice and permitting requirements.

With the increasing production of cannabis for recreational purposes, more conflicts with neighbors are likely. This is a situation where an ounce of prevention by implementing a wide-range of BMPs could go a long way toward reducing the risks of litigation and enforcement.

We recently discussed the impact of the Harborside opinion on cannabis tax planning, a tax court decision that disturbed, but didn’t really surprise, those of us who regularly work on the application of tax rules in the cannabis industry. The industry faces a secondary assault following the U.S. Tax Court’s opinion in Alternative Health Care Advocates. The opinion in Alternative raises new — more surprising and more disturbing — concerns regarding common cannabis tax planning strategies and focuses on the use of management companies.

Alternative obtained cannabis from its patient-members. It would prepare and process this cannabis for sale to its patient-members, which included trimming, drying, breaking down cannabis into gram or eighth-of-an-ounce increments, and maintaining clones. Additionally, Alternative obtained edibles, tinctures, oils, concentrates and topicals from its members in a condition ready for resale. The opinion notes that Alternative hired “processors” “through Wellness.”

Interestingly, both Alternative and Wellness maintained bank accounts with Bank of America and Chase Bank. Alternative operated within a “closed-loop” system. The closed-loop system required Alternative to limit both purchases and sales to patient-members. As such, Alternative purchased items from patient-members and sold cannabis items to them. Wellness paid Alternative’s other expenses, including advertising, wages and rent. Alternative reimbursed Wellness for these items. However, at times, Alternative directly paid for such items.

For the years in question, Alternative filed C corporation returns (Form 1120) and Wellness filed S corporation returns (Form 1120-S) while reporting the distributable share of Wellness income or loss to each Wellness shareholder on a schedule K-1. Both Wellness and Alternative reported gross income and other deductions. Additionally, Alternative reduced its gross receipts by its cost of goods sold. The tax returns filed by Alternative and Wellness did not reflect any disallowed expenses under IRC section 280E, and the IRS challenged each taxpayer’s respective position.

It should not surprise any of our readers that Alternative, a California medical marijuana dispensary, was disallowed expenses other than cost of goods sold under section 280E. What may be surprising is that the Tax Court extended the application of section 280E to Wellness, an S corporation acting as a “management” company for the dispensary.

[T]he only difference between what Alternative did and what Wellness did (since Alternative only acted through Wellness) is that Alternative had title to the marijuana and Wellness did not. Wellness employees were directly involved in the provision of medical marijuana to the patient-members of Alternative’s dispensary. While Wellness and Alternative were legally separate, Wellness employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative); that was Wellness’ primary business. We do not read the term “trafficking” to require Wellness to have had title to the marijuana its employees were purchasing and selling. Neither that section nor the nontax statute on trafficking limits application to sales on one’s own behalf rather than on behalf of another. Without clear authority, we will not read such a limitation into these provisions.

The analysis is troubling for several reasons. First, it ignores any contractual relationship between Alternative and Wellness. Second, it ignores any principal and agent relationship between Alternative and the employees provided by Wellness to Alternative. Third, a reasonable and logical expansion of the analysis suggests that dispensary employees are subject to section 280E. Fourth, the holding violates the tax principle that ambiguity in revenue raising provisions — notably IRC section 280E — should be construed in the taxpayer’s favor rather than the government’s favor.

The collateral damage of Alternative is unclear, and may suggest that cannabis companies should carefully (re)consider the use of management companies. Query whether it makes sense to restructure some management companies as so-called employee leasing companies. In the employee leasing arrangement context, the employees should be under the direction and control of the licensed entity rather than the employer of record. While the holding involves entities “directly involved” with cannabis, it suggests that real estate leasing and intellectual property leasing structures may face similar attacks in the future. Cannabis companies should carefully consider the tax risks of any tax planning strategies and determine if the potential benefits outweigh the associated risks.

The new Agricultural Improvement Act of 2018 (Pub. L. 115-334) (the “Act”) was signed into law by President Trump on December 20, 2018. Much press has been devoted to the fact that the Act generally legalizes industrial hemp and will provide federal Crop Insurance for that crop.

While this is potentially good news for farmers and their bankers, questions remain for bankers about how they can effectively identify a legal hemp crop and distinguish it from an illegal marijuana crop. Although industrial hemp typically looks very different from marijuana grown for recreational consumption, both are derived from the same genetic species: cannabis sativa. Under the Act, the legal difference appears to be based on the THC levels in the processed (or “dry weight”) product.

The Act defines “hemp” to mean: “the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3 percent on a dry weight basis.” Act, §10113.

The revisions to the Federal Insurance Crop Act use that same definition and provide that “hemp” as so defined can be insured under the federal crop program. Act §§11101 and 11119.

Thus, the legality of marijuana under federal law will be determined by whether the THC it contains, by dry weight, is less than 0.3 percent. If the THC level is 0.3 percent or greater, the crop is still subject to the federal Controlled Substance Act as a Schedule 1 drug (similar to heroin).

As the Act goes into effect and federal regulators weigh in on it, banks will need to consider whether they are willing to lend against the legal crop as they would against any other agricultural product, and will also have to examine how they can ensure that the crop against which they are lending has a legally acceptable THC level.

We are starting to work with botanists and others to see how lenders can lend against hemp crops and audit the crop’s compliance with the Act. Certainly, the approach that will be taken by the Federal Crop Insurance Corporation and the Secretary of Agriculture concerning the Corporation’s providing of crop insurance for hemp will be critical for bankers wanting to enter the field.

The U.S. Tax Court’s recent Harborside opinion confirmed what we have warned our clients for quite some time: section 263A is unavailable for any cannabis business that traffics a Schedule I or II controlled substance. This conclusion is consistent with the IRS view espoused in a 2015 IRS Chief Counsel Advice memorandum and the flush language in section 263A, which states taxpayers cannot use section 263A to deduct an otherwise nondeductible item. Many cannabis businesses have relied on section 263A to capitalize expenses that would otherwise be non-deductible under section 280E. Those taxpayers should reconsider their tax return filing positions on not only a go-forward basis, but also for purposes of correcting previously filed returns.

Query: How should cannabis businesses account for their inventories going forward?

There are really two parts to the answer. First, taxpayers should consider the impact of changing their method of accounting for determining cost of goods sold (COGS), and whether it is appropriate to file IRS Form 3115 (Application for Change in Accounting Method) because they adopted a different COGS accounting method. Remember, even an erroneous method of accounting is still a method that usually requires filing that form and sometimes requires IRS permission.

Second, taxpayers should identify and use a permitted method under section 471. Those methods include the following:

Certain Small Businesses (section 471(c))

Taxpayers that are not a tax shelter under section 448(a)(3) and meet the gross receipts test found in section 448(c) may rely on their book method of determining COGS for tax purposes. Stated differently, qualifying taxpayers do not need to make book-to-tax adjustments for COGS. The gross receipts test in section 448(c) generally requires average annual gross receipts for the trailing three tax years not to exceed $25 million. Taxpayers in this category may face little or no impact when they aggressively capitalize costs into COGS for book purposes.

Herd Mentality (Reg. § 1.471-2(a)(1))

Section 471(a) grants broad authority to the IRS to adjust inventories to (1) clearly reflect income and (2) conform to the best practices of the trade or business. The conjunctive “and” requirement is interesting. It suggests that if the industry adopts best practices of capitalizing the majority of direct and indirect costs into COGS, then the IRS cannot adjust the taxpayer’s method solely for the purpose of “clearly reflecting income.” The IRS can only make an adjustment to “clearly reflect income” if it also satisfies the second prong of conforming as nearly as possible to best accounting practices. This suggests that a herd mentality within the industry may limit IRS ability to make COGS adjustments using authority granted to them in section 471.

Inventories at Cost (Reg. § 1.471-3)

Most accountants are familiar with using the inventories at cost method. Taxpayers calculate COGS using the following formula: Beginning inventory + purchases – ending inventory = COGS.

For companies that manufacture the inventory they sell, the formula modifies the purchase component to include: (1) the cost of raw materials and supplies entering into or consumed in the production process, (2) direct labor costs, and (3) indirect production costs incident and necessary for the production of the inventory (not including management expenses, selling costs, or return on capital). As you may suspect, cannabis producers receive a much better result under this method than resellers get.

Lower of Cost or Market (Reg. § 1.471-4)

The lower of cost or market method generally permits taxpayers to write down ending inventory when the carrying or book cost of that inventory is less than its current market value. Such a rule is generally taxpayer favorable because it permits the taxpayer to claim earlier the loss that otherwise arises when the taxpayer eventually sells the inventory. Cannabis businesses should receive a similar benefit. For instance, most markets face declining prices. Using the lower of cost or market method might increase the business’s COGS when production or purchasing costs are higher than the market value of their ending inventory.

Retail Merchants (Reg. § 1.471-8)

The retail method of inventory accounting is the following formula: a “Cost Compliment” multiplied by the retail sales price of goods on hand at the end of the taxable year. The cost compliment is a fraction calculated as (1) the value of beginning inventory plus the cost of goods purchased during the year divided by (2) the retail selling prices of beginning inventory plus the retail selling prices of goods purchased during the year, adjusted for all permanent markups and markdowns. This method is unlikely to produce a very favorable result for most cannabis companies as it does not capitalize indirect costs into COGS. As such, taxpayers would likely be denied deductions for indirect costs under section 280E.

Manufacturers (Reg. § 1.471-11)

This method is the closest method to section 263A and permits capitalization of both direct and indirect production costs — full absorption — to compute COGS. Production costs include direct production costs, as well as fixed and variable indirect production costs. The regulation places indirect costs into one of three buckets: (1) costs that must be included in COGS, (2) costs that are not required to be included in COGS, and (3) costs that are includable in COGS depending on the taxpayer’s book treatment. The word choice in the not required bucket is interesting. It suggests that taxpayers do not face a blanket prohibition of using those costs in COGS, and that taxpayers might in fact be able to capitalize COGS whenever doing so is consistent with industry best practices.

Query: What is the penalty risk for using section 263A?

On December 20, the Tax Court released a subsequent opinion in Harborside that is limited to discussing the application of penalties under section 6662. Harborside avoided penalties because the court determined that they acted reasonably and in good faith. However, it is interesting and noteworthy that the tax years in question were 2007 through 2012. All of those years are prior to the IRS CCA stating the IRS position that cannabis companies cannot rely on section 263A. This suggests that the Tax Court may be less forgiving for tax returns filed after the IRS published the CCA and taxpayers should consider amended returns for open tax years. The Tax Court does provide some insight into penalty relief for tax returns filed after the CCA. They note that the IRS had not promulgated regulations for section 280E, and no such regulations exist today.

The Takeaway

There are significant tax advantages to cannabis businesses that “manufacture” their inventory rather than buying it for resale. As such, cannabis businesses can better position themselves by vertically integrating — typically by producing or processing cannabis — along with retail activities. Tax policy may drive both vertical integration and consolidation within the industry.

The United States has a long history with hemp, legally distinguished from marijuana, but genetically identical as the plant cannabis sativa (L.) — now, hemp is set to reemerge in U.S. agriculture as an important crop following passage of the 2018 Farm Bill expected sometime this week. There had been a lot of speculation, and disappointment, regarding the Bill’s hang up to date — in fact, many had resigned hope of the Bill passing this year at all and already started referring to it as the 2019 Farm Bill. Most people in the agriculture industry are very pleased that the Bill is finally moving forward.

Specific to hemp, people familiar with it as an industrial crop anticipate that the hemp will quickly grow into an important mainstream commodity. Widespread interest in hemp’s chemical derivatives, such as the non-psychoactive substance CBD, is one of the driving factors. Agriculture businesses that have already invested heavily in the industry are thrilled. Although hemp was previously considered an essential crop in the United States dating back to the original 13 colonies and grown by many founding fathers, it has been mostly illegal, except in limited circumstances, since well before the current generation of farmers took over from their own fathers.

Importantly however, it should be noted that although CBD is already big business in the U.S., broader allowances for the production of hemp under the new Farm Bill will not blanket legalize either human or animal consumption of CBD unless any such CBD containing products have specifically obtained approval from the Food and Drug Administration (FDA) under the Food, Drug, and Cosmetics Act (FDCA). Currently only a single substance, Epidiolex, has obtained such approval.

But there’s a lot more to hemp than CBD, such as its more traditional, well-known use as a natural fiber in ropes and textiles. Less well-known, however, may be hemp’s increasing popularity as a composite substrate (fiberglass) or for reinforcing concrete. Increased access and availability of hemp for such purposes will greatly improve research opportunities for other potentially useful applications. Hemp’s inclusion in this year’s Farm Bill signals its widespread shift back to mainstream acceptance over the last decade.

So, ready or not — here comes hemp — or perhaps more accurately, the return of hemp.

Earlier this week the U.S. Tax Court issued its long-awaited opinion for the Harborsidecase, which addresses several issues that impact cannabis tax planning strategies. Those issues include:

Definition of “consists of” as used in section 280E;

A Narrow view of CHAMP and when a business engages in two or more trades or businesses;

Hints that separate taxpayers may be aggregated as engaging in separate trades or businesses;

Holds that section 263A does not apply to a trafficking business subject to section 280E and must rely on section 471 COGS methodologies; and

Interprets the meaning of “produce” for purposes of the COGS method found in Reg. 1.471-11.

The opinion does not discuss whether Harborside is liable for accuracy-related penalties under section 6662(a). Also, the Tax Court did not adopt the IRS position previously asserted in an IRS Chief Counsel Advice memorandum — that taxpayers must use the section 471 methodologies that existed when Congress enacted section 280E. We previously questioned that IRS position.

We try not to blog about developments outside the scope of our expertise. However, because many of our clients are very involved in Canada (or want to be), we want to share with you this article (authored by a very reputable Canadian law firm) about Ontario’s recently enacted Cannabis License Act and related regulations. Enacted last month, this legislation provides a mechanism for privately-owned business to become licensed retailers in Ontario, though the government-run Ontario Cannabis Retail Corporation remains the exclusive wholesaler and online retailer. The window for license applications is expected to open December 17.

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Our Cannabis Team

Throughout its 140 years, Lane Powell has embraced change. The cannabis landscape is changing and Lane Powell is helping lead that change. We know cannabis businesses have unique needs and are proud to use our vast array of experience to help legal cannabis businesses in the Northwest navigate a complex regulatory environment.